Saturday, March 22, 2008

Writing in the San Francisco Chronicle, Kathleen Pender argues that the experiments currently being conducted by the federal government to rescue the financial markets aren't immune to their own -- and often unforeseen -- perils. In other words, like drugs, there could be side effects:

It would be nice if the federal government would fess up about the potential side effects of the medicine it has been delivering in increasing doses to the financial markets.

That might be hard to do, considering that most of these experimental remedies are being invented on the spot and unleashed on the market without a bit of the rigorous testing required of new drugs.

But make no mistake: If the feds succeed in preventing a financial collapse, there will be a price to pay...

Economists say they are likely to include some combination of higher taxes, higher interest rates, higher inflation, slower economic growth and a weaker dollar.

Let's remember for a moment what got us into this predicament.

After the stock market crash in 2000 and the terrorist attacks in 2001, the Federal Reserve kept interest rates too low for too long. The federal funds rate stayed at 1 percent throughout 2003, long after the 2001 recession had ended.

Low rates fueled speculation in housing and the creation of new mortgages and mortgage-backed securities that were sloppily underwritten, poorly rated and widely misunderstood. Hedge funds and other investors used these securities to borrow money to buy other assets, creating a mountain of debt atop a small slice of fragile collateral.

Banking regulators, Congress or the Bush administration could have stepped in to restore some sanity to the markets but declined to do so in the name of homeownership and free enterprise...

"We are going to nationalize the mortgage market," says Ken Rosen, chairman of the Fisher Center for Real Estate at UC Berkeley, consultant and hedge fund manager. "It's the outcome of not regulating at the right time."

Economists say they are likely to include some combination of higher taxes, higher interest rates, higher inflation, slower economic growth and a weaker dollar.

As much as he dislikes it, Rosen says, it's the right thing to do in the short run. "If they did not stop the credit crisis, we would have something much worse - a meltdown like we had in the '30s," he says. But "it's not a good thing in the long run."

Rosen predicts that when all is said and done, there could be as much as $1 trillion worth of losses in the financial system. He predicts that investors will bear 60 percent of the losses and the government could shoulder the rest...

To pay for these losses, the government will have to raise taxes, sell more debt or both.

Near term, Rosen predicts that the Fed will have to keep cutting interest rates to prevent further weakness in housing and the economy. That will put further downward pressure on the dollar. A falling dollar will fuel inflation because imports, oil and other commodities will cost more.

Long term, the government will have to raise interest rates to entice foreigners to buy our debt.